Last updated: May 20, 2022
It can be hard for early-stage founders to determine a fair valuation for their startup, especially if they seek seed- or series A funding. As a startup founder, you need to know whether your venture is being valued reasonably, no matter if the funding is coming from friends and family or angel investors and venture capital firms.
Table of contents
- What is startup valuation?
- Startup valuation methods
- Can you increase your startup's valuation?
- Valuation tips for startup founders
- What do investors look for while valuing early-stage startups?
- What is a good revenue multiple for a startup?
- Conclusion
What is startup valuation?
Startup valuation is a process of measuring or quantifying a company's net worth in monetary terms.
Why do you need startup valuation?
Building a startup is hard work. Many moving parts need to come together and work in perfect harmony for a startup to be a success. Many people have an idea, but it isn't worth anything unless it is executed well, market conditions are favourable, you are solving a unique problem, and you also create value in the process. It is hard to put a price on achieving all of this, but it is important to do it.
There are multiple reasons that your startup needs to be valued. A startup will have to raise funds at some point or it will get acquired by another company. In both cases, the net worth of your business has to be fairly determined.
Other key reasons a startup needs to be valued are – taxation, establishing the current share price, or deciding how much equity an entrepreneur should give an investor. Being valued in dollar terms also gives a company credibility. It will get relevant people and companies to notice you and help you source more funding and business opportunities.
There are different methods of calculating a startup's valuation, and each may result in a different valuation. Investors will use some of the below factors when determining how much your startup is worth:
Founders and management
Future earning potential
Industry your startup is operating in
Market value of assets
Intangible assets like brand or goodwill
Cash flow analysis
Analysis of financial statements
Before we dive into the various valuation methods, let’s establish what some important terms mean.
What is pre-money and post-money valuation?
Pre-money valuation is the valuation of a company before it gets outside investment. It is used by investors to assess how much a company is worth before they invest money in it. Post-money valuation is valuation after a funding round; it includes the value of funding the company raises.
It is important to know post-money valuation because it determines how much equity an investor will own in a company after a funding round.
Let’s take an example:
Assume that an investor values a company at £10 million (pre-money) and puts in £2 million as funding. While the investor's ownership is being determined, it will be essential to establish whether it will be based on pre-money ($10 million) or post-money valuation (£12 million).
What are pre-revenue startups?
Pre-revenue startups are new companies that aren't selling their products at scale.
Startup valuation methods
Let’s lay out the most important startup valuation methods with some of their advantages and disadvantages:
Berkus method
Developed by venture capitalist and angel investor Dave Berkus, this method was created to value pre-revenue startups. Also known as the stage development method, it involves assigning a value to five critical elements of a startup to arrive at a pre-revenue valuation.
These elements are:
Sound idea
Strength of the management team
Strategic relationships or alliances
Completed prototype or product
Product rollout or sales
As per this method, each element counts for a maximum of $500,000, but it is an indicative value that you can deviate from depending on market conditions in the country or region. You can assign a value to each category to arrive at a pre-money valuation.
Berkus says different interpretations of this method have substituted various elements, but at the core, it is about de-risking early-stage investment. For example, you could add an element about Food and Drug Administration (FDA) approvals in a health-tech company.
Berkus also mentions that this method is no longer applicable once a company starts earning revenue, which can be used to project value over time.
Advantages
It is a simple method that can be modified or personalised.
It does not depend on forecasts.
It considers important risk management elements like the management team, which can truly impact how well a startup does in the future.
Disadvantages
This method assigns equal importance to all factors and ignores certain elements like financial risk that startups carry.
Venture capital method
The venture capital method takes into account the time and risk factors for investors. The method is focused on the future; it is used by investors that are looking to exit in a few years. The first step using this method is to calculate the terminal value, which is the expected value of the business at a specific date in the future.
To calculate the terminal value, you will need to know the projected revenue and profit margin in the harvest year and the industry stock price-to-earnings ratio (P/E) ratio.
The formula for terminal value:
Projected revenue x Projected margin x P/E
Earnings x P/E
The second step is to calculate back to arrive at a pre-money valuation. To calculate the pre-money valuation, you will need to know the required return on investment and the investment amount.
The formula to calculate pre-money valuation is:
Terminal value / ROI – Investment amount
Advantages
It is easy to use.
Good for pre-revenue companies as it allows for the calculation of estimated exit value rather than projected cash flow.
Disadvantages
This method doesn't consider elements essential to startups like management team, product, etc. It only focuses on the rate of return.
It is hard to determine the exact timing of an exit since it depends on a variety of factors that can be internal or external. It also depends on the startup finding a buyer or filing for an IPO right when the investor wants an exit. It is hard to determine the exact timing of any of these as they depend on how fast a startup has a marketable product or how long it takes to mature.
Comparable transactions method
This method values a startup by determining how much similar companies were acquired for. You can determine a value range for your startup by comparing it with other startups with similar products.
Example
An eCommerce startup x, with a million users on its app, was recently acquired for $50 million. This values each user at $50. Let's say your app has 100,000 users. This means your eCommerce company could be valued at about $5 million. However, you will have to factor in different variables.
Let's say that company x had 10,000 merchants on their app, whereas you only have 4,000. You will need to make adjustments for that.
Advantages
This method is based on precedent, and investors familiar with certain groups or types of startups find it easy to make projections.
Disadvantages
This method assumes that your startup will have a similar outcome or trajectory as a comparable company. That is not always true. Sometimes companies change tack, add or remove revenue streams, or even change the course of their business completely. Knowing the right metrics to use is essential. Companies also have unique risks that this method doesn't take into account.
This method doesn't consider the management team, the unique product, or the prototype your company may have developed.
Discounted cash flow method
Discounted cash flow method is used to determine the present value of a company’s future cash flows. Using this method, you can calculate the value of an investment by using market analysis to forecast a company's future cash flow and then applying a discount rate to derive its present value.
If the discounted cash flow is more than the current investment cost, it will have positive returns. The risk associated with this method is that the forecasted cash flow can be inaccurate.
Finology offers a great calculator to help calculate discounted cash flow.
Advantages
It is an objective way to arrive at the intrinsic value of a business and doesn't need to compare your startup with similar companies.
This detailed method uses specific numbers like cash flow projections to arrive at a value.
Disadvantages
It relies on cash flow projections, which are impacted by many variables. The discounted cash flow method is also heavily reliant on the quality of these projections.
It is hard to predict how long a firm that has just started operations will take to mature or if it will even survive. It is hard to have accurate projections or apply the right discount rate in such a scenario. Discount rates are calculated based on mature companies that don’t carry the same risk as startups.
This method relies on the business plan to project all cash flows. Usually, cash flows are predicted based on historical cash flow, which is not possible in the case of startups. Even if such data is available, it will not accurately reflect future cash flow projections.
First Chicago method
Developed by the First Chicago Corporation Venture Capital, this method used a mix of venture capital method and the discounted cash flow method. Using the First Chicago method, you will first determine three different scenarios of how the startup could evolve - the worst, the base, and the best.
You then calculate the valuation for each scenario using either the venture capital or the discounted cash flow method.
Combine the estimates for all three scenarios to arrive at a weighted average valuation. Now, decide on a percentage that reflects each scenario’s probability to happen. The next step is to calculate the expected value of outcomes and arrive at the overall weighted valuation.
Advantages
The First Chicago method considers all the risks associated with investing in a particular startup as both the worst and best case scenarios are included in the final value.
Disadvantages
Accurate discount rates are hard to determine for startups.
Scorecard valuation method/Bill Payne valuation method
This method is most suitable for angel investors who have a deep understanding of similar startups in a region. Investors use this method for investment in both pre-seed and seed-stage companies. Using this method, investors establish a startup's pre-money valuation by comparing it to other angel-funded ventures in the same business sector and similar stage of development.
Here are four steps of valuing startups based on this method:
The first step in this method is to calculate the average value of similar startups in the ecosystem.
The second step involves comparing the startup in question with similar startups based on the following factors and assigning each factor a weightage based on its influence.
Strength of the management team (0-30%)
Size of the opportunity ( 0-25%)
Product/technology (0-15%)
Competitive environment (0-10%)
Marketing and sales (0-10%)
Requirement for additional capital (0-5%)
Other factors (0-5%)
3. The next step is to assign a score to each of these factors and determine a final score for the startup. You can find a detailed method in this Angel Capital Association blog post written by Payne himself.
4. In the last step, the following formula is used to calculate the startup’s value.
Startup value: Total startup score * Average valuation of similar startups
Advantages
The scorecard method covers more areas compared to the Berkus method.
Disadvantages
It leaves out some areas that the more detailed methods like the risk factor summation method cover.
Risk factor summation method
The risk factor summation method combines some aspects of the scorecard method and the Berkus method. The first step is similar to the scorecard valuation method, where you determine the industry average valuation for a startup.
The second step is to consider the following risk factors associated with the startup and the industry it operates in:
Management risk
Stage of the business
Political risk
Manufacturing risk
Sales and marketing risk
Capital raising risk
Competition risk
Technology risk
Risk of Litigation
International risk
Reputation risk
Exit value risk
The third step is to assign ratings to all the risk factors ranging from -2 to +2 (a negative rating will reduce the final valuation while positive ratings add to it). Each risk factor is scored as:
+2 – very positive for growing the startup and exiting successfully
+1 – positive
0 – neutral
-1 – negative
-2 – very negative
The next step is to adjust the startup's average pre-money valuation. It is adjusted positively or negatively by $250,000 for each point added or deducted. This means that $250,000 is added for every +1 and +$500,000 for a +2. Similarly, $250,000 is deducted for every -1, and $500,000 is deducted for every -2.
Advantages
It considers the major business risks that are important while valuing startups.
Disadvantages
A lot depends on how accurately ratings are assigned to these risks.
Cost-to-duplicate method
As the name suggests, this method determines how much it would cost to build a similar startup. The method takes into consideration the costs associated with the startup, including product development, prototype costs, patent costs, research and development costs, and the value of its physical assets.
Advantages
For investors, it is an objective way of valuing a startup. Investors can make a rational decision on the amount of money they want to invest as it will be in keeping with how much it would cost to build a similar startup.
Disadvantages
This method does not consider intangible assets, which are important for a startup. A founder's team and their experience, goodwill, etc., are important factors in building a business.
The method ignores future growth and sales projections, making the valuation unreliable.
Book value method
This method relies on the tangible assets of a startup. It is measured as the difference between a company’s total assets and total liabilities. It does not take into account the future profitability of the startup.
Calculation
Book value = Assets - Liabilities
Advantages
The book value method is suitable for capital-intensive companies with minimal intangible value. If your startup owns manufacturing facilities, equipment, land, etc, this method can efficiently be used to value it.
Disadvantages
It doesn't accurately value intangible assets like patents, copyrights, etc.
Startups may develop products at very low costs, and the value of developing a product reflected on the balance sheet may not accurately represent the true value.
Can you increase your startup's valuation?
Yes, here's how:
Get your product out there
Nothing will excite an investor more than seeing your product out in the market, where it receives good reviews and is appreciated by customers.
A good team is half the battle won
You must have heard that investors put their money behind people. If investors believe a team has the potential to deliver, it can drive your valuation up. A good team is a mix of people with skills, knowledge, and passion. Investors also like diverse teams who really understand different kinds of customers and bring a unique set of skills to the table.
Pro tip: Don't shy away from experienced folks with industry experience; if you want to disrupt an industry, it's good to have insiders on your team.
Everyone loves a good story
For pre-seed or early-stage startups, a good story and presentation are key. Take the investors on a journey, excite them, make them believe in your story. You should be able to excite investors about the idea so much that they don't care about the price. If you can get enough people to believe in your idea, you can easily drive the valuation up.
Start pulling in revenue
Pre-revenue startups get funded all the time, but if you have figured out a revenue model, start moving the needle on getting in big customers and closing deals. It's not always important how much money you are making but that you are making it. It helps investors get a clearer idea of future sales and potential. This will help push your valuation higher.
Build a following
Internet startups benefit from building a network on social media platforms like Facebook, Instagram, or even LinkedIn. Having dedicated followers, even a small number, is attractive for investors and can help you push your valuation higher and create a "network effect."
Take actor and entrepreneur Gwyneth Paltrow's lifestyle brand Goop as an example. It started as a weekly newsletter in 2008 and has raised more than $75 million since.
Valuation tips for startup founders
Here are some helpful tips for startups that are looking to raise capital:
Seek help from experts
This is important for pre-revenue startups that are seeking funds. Investors will employ one of the methods above to value your company, but you should determine your valuation with the help of an expert before you pitch. This will help you protect your interests and get a fair price.
Consider how much equity you are willing to give away
It's important for startup founders to know how much equity they are ready to give up. Usually, for seed rounds, investors will take 10-20% of your business’s equity.
Evaluate similar companies
You can look at your competition or similar companies in other geographies to estimate where you stand. It also helps to evaluate the valuation of your closest competitors, you may not be valued the same, but it will give you a sense of what fair value should look like.
Client testimonials
For Internet startups, good reviews from your customers reflect the faith they put in your product. It will work as proof of concept and give investors a fair idea about why your product is working.
What do investors look for while valuing early-stage startups?
Here are some positive and negative aspects that might work in your favour or against you while your startup is being valued.
Factors that will work for you
Distribution
It is not often talked about, but investors like companies that have distribution channels in place. An interesting example here is the direct-to-consumer (D2C) brand revolution that bypassed the traditional selling model through distributors and retailers. Using this approach, companies like Dollar Shave Club and rival Harry’s together captured 14% of U.S. razor blade sales.
Traction
If you are gaining traction in the market and have a growing customer portfolio and returning customers, you could raise $1 million or more.
Prototype
If you have a prototype in place and are ready to launch in the market, the investor's interest will be piqued, and you are likely to get funded.
Sales
Nothing excites investors more than a company with a revenue stream in place and recurring clients.
Factors that may work against you:
Management team
As we mentioned earlier, for a new company, people are everything. If the investors cannot trust the key team or don't see them having the necessary skills or expertise, it will work against your company.
Bad timing for the industry
If your industry is performing poorly, investors may be dissuaded from investing or wait till the sector starts to look up.
No product-market fit
If the investor doesn't see product-market fit or believes the market is not ready for your product, they will refrain from funding.
Lack of vision
Founders like to invest in companies with a clear vision of what they are building and how they plan to grow. A lack of clarity is a deterrent for investors.
What is a good revenue multiple for a startup?
Startups can be valued using a revenue multiple compared to EBITDA (earnings before interest, tax, depreciation, and amortisation) multiple, which uses a company's EBITDA to arrive at its valuation. Startups, especially in the tech industry, grow fast and may have negative EBITDA, which means that investors can calculate valuation using revenue.
The method is fairly simple. Investors and the entrepreneur negotiate a multiple based on the company's growth rate. If a company is growing in double digits, let's say above 40%, it can be a multiple of more than 6. It will be lower if your startup is growing at a slower pace.
Conclusion
Valuing a startup may seem like a complicated process but you can consult with a professional to help you arrive at a fair valuation for your company. This will help you negotiate a better deal if you are in the process of seeking funding. The key is to find the right method that works for the kind of startup you have, the stage of development it is in, and the valuation of similar startups in the business sector.
You may want to have a very high valuation for your startup, but that comes with very high growth expectations as well. Arriving at the right valuation will help you plan the future of your business better.
Written by
Sam founded his first startup back in 2010 and has since been building startups in the Content Marketing, SEO, eCommerce and SaaS verticals. Sam is a generalist with deep knowledge of lead generation and scaling acquisition and sales.